Cashing in on Telstra

Richard Hemming

The Australian stock market is trading at 19-month highs and has climbed about 23 per cent in the past eight months.

Investors are benefiting from the perception of improved global certainty and, domestically, the prospect of interest rate cuts.

Now is the time to be taking some money off the table if you have made profits.

Let Radar help you make the big decision.

First, it's worth remembering that stock pickers who bought early near the conclusion of the financial crisis will be sitting on big profits. Even if the market falls, they will be ready to sell again.

So don't think that if there is weakness, the market will automatically bounce back.

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Telcos are historically expensive

Telecommunications is one sector where investors might consider cashing in on some big gains.

Companies in the sector are without exception trading almost irrationally at historically expensive levels.

According to Goldman Sachs, in 2012, Telecom stocks, led by Telstra, achieved a 23 per cent increase in their PE multiple. The average PE went from 11 times to 14 times. In the case of TPG, its one year forward PE has been re-rated upwards by 72 per cent!

In smaller telecoms stocks, the re-rating was 31 per cent. Shares such as iiNet went from trading on a PE of 9 times to close to 12 times.

This comes in the wake of massive share price gains on little, if any earnings improvement. In the past year Telstra has returned close to 50 per cent, while its net profit for the current year is forecast to grow less than 3 per cent a year for the next three years, by Macquarie Equities Research.

Free cash flow is nirvana for investors

Investors love the certainty of future profits, and these companies, whose businesses contain more acronyms than you would hear in a CIA briefing, have ticked that box in the past.

The earnings of companies like Telstra, iiNet, TPG, M2 Communications benefit from relatively good operating leverage, meaning their revenues at a certain point, convert straight to the bottom line. This is one reason why they generally have such good free cash flow.

Big free cash flow is a nirvana for investors, and refers to monies which enter the company's coffers after the payment of all its costs, its capital expenditure commitments, and its dividends.

But the thing is, the days of big free cash flow are over for the telcos. They are now paying big money just to stand still. And we're talking BIG – potentially $12 billion to be spent in 2013 alone (according to our friends at Goldman Sachs).

The NBN and the ensuing pain

The money is being spent on wireless infrastructure (about $3 billion), digital spectrum for mobile phones (Communications Minister Stephen Conroy increased spectrum costs by $800 million, and costs for the industry will be as much as $4.5 billion) and about $3.2 billion will be invested in the national broadband network (NBN) which is running behind schedule.

Ah yes, the NBN. Never has there been more uncertainty about what the telecommunications landscape will look like because of this monolith. Analysts are busy telling us that a Coalition government won't make much difference to the overall picture, but even they don't know what effect it will have on the profit margins of the various participants in the industry.

What we do have some idea of is that the NBN will effectively take $20 billion of revenues out of the system, and this will be the high margin, big profit business currently undertaken by the existing participants.

Whatever you think about valuation and the outlook for telecommunications in Australia, it will be interesting to hear what Telstra's chief executive David Thodey says next Thursday at his company's half-year result.

PS. We also think it's worth taking some profits on the banks.

Click here to access the fortnightly newsletter Under the Radar Report: Small Caps edited by Richard Hemming. Visit here for more Under the Radar articles.